How to Reduce Your Taxes by Being an S Corporation

Looking for an effective tax reduction strategy for your small business? This article explains how to reduce your taxes by choosing to be taxed as an S corporation.

First, a question: What do all the following small business owners have in common?
1) C corporation shareholders; 2) sole proprietors; 3) partnership partners; and 4) limited liability company (LLC) owners who are being taxed like a sole proprietorship or a partnership.

Answer: Each of these business owners has the potential to pay less tax by choosing to be taxed like an S corporation.

C corporation owners face the dreaded double taxation of corporation profits. Believe it or not, corporate profits are usually taxed twice. The corporation must pay its own corporate income tax on those profits. And if the corporation distributes those profits to the shareholders as dividends, those dividends get taxed a second time on the personal income tax returns of the individual shareholders. Ouch!

Sole proprietors, partnership partners and LLC owners all face the dreaded self-employment (SE) tax on their business profits. And unlike an employee, they pay twice as much SE tax (15.3%) than their employee counterparts pay in federal payroll tax (7.65%).

What are all these small business owners to do? One option is to choose to be taxed like an S corporation. An existing C corporation that switches to S corporation status can avoid the double taxation of corporate profits. This is possible because an S corporation typically doesn’t pay any corporate income tax on profits. The profits are only taxed to the individual shareholders on their personal income tax return. End result: no double taxation.

Sole proprietors, partners and LLC members can legally reduce SE tax by receiving reasonable employee compensation from the S corporation. If this compensation is less than the total business profit, the remaining profit legally avoids payroll tax, because only employee wages/salary is subject to payroll taxes.

How do you “choose” to be taxed like an S corporation? This choice is made by filing Form 2553 with the IRS, Election by a Small Business Corporation. Think of this form as an application by an existing small business to be treated like an S corporation for tax purposes. Here’s how it works for each entity type:

C Corporation. File form 2553. You don’t have to shut down the existing corporation; nor do you have to form a new corporation. The existing corporation continues to exist, just like it did before, as a corporation in good standing of the state in which the corporation was formed.

NOTE: Be sure to consult a tax professional before converting a C Corporation to an S Corporation. There are several potential pitfalls here – complicated issues (such as carryover losses, built-in gains, LIFO inventories and passive income) can wreak havoc on your corporation’s tax situation, so do your homework and get some help before taking the S Corporation plunge.

Limited Liability Company. Specifically, I’m referring to an LLC that is not already being taxed as a corporation. If that’s you, file Form 2553 to be taxed as an S Corp. You don’t have to shut down the LLC and/or form a new corporation. The original LLC remains intact for legal purposes. You simply submit Form 2553 in order to tell the IRS you want your business treated like an S Corporation.

Sole Proprietors. Before filing Form 2553, you must form a corporation or LLC. Once this new entity is set up, submit Form 2553.

Important: There are specific rules regarding the timing of the Form 2553 filing, so be sure to read the instructions carefully or consult with your tax professional.

Even More Important: Obviously, a 500-word article cannot explain the various factors that must be addressed before deciding how you want your business to be taxed. My purpose here is to get you to start thinking about it and to introduce you to the possibility that an S Corporation may be the best fit for you because of the potential tax savings.

Got questions? Good. Now take action to get answers to those questions.